Indexed Annuities

• An annuity is a contract. A contract is an agreement between an individual and an insurance company. The terms of the agreement are spelled out in a document called the policy.

• All annuities involve an individual paying some amount or amounts of money (referred to as "purchase premium" or " premium") to an
  insurance company and later getting money back from the company in one form or another, usually either in a lump sum or stream of income
  payments.

• The individual has a number of options for receiving money back from the insurance company. One feature that makes annuities unique among
  financial vehicles is that the individual can choose to receive a regular income that can be guaranteed to last as long as he or she lives.

• Because the individual can name a beneficiary to receive annuity values in the event of his or her death, annuity values need not become part
  of the individual's probate estate but can pass to the beneficiary free of probate's costs and delays.

With most annuities, it is anticipated that many years may go by before the individual will choose to begin receiving income. The period prior to the time income payments begin is called the "deferral period", and annuities that have a deferral period are known as "deferred annuities”.

During the deferral period, the premium paid to the company has the potential to accumulate earnings and grow to a greater sum than was paid by the individual. To encourage the use of deferred annuities as long-term savings vehicles, annuity earnings are subject to special income tax treatment. As long as the accumulations stay in the annuity, they are not taxed. However, if they are removed from the annuity before the individual is 591/2, then in addition to the regular income tax, they are also subject to an IRS imposed 10% penalty tax unless the individual dies, has become disabled, or takes equal payments based on life expectancy.

Different types of annuities use different methods of crediting accumulated interest to policy values. From an interest-crediting standpoint, indexed annuities are generally considered to be a type of fixed annuity, with an important difference from traditional fixed annuities. To make the significance of that difference clear, let's begin by looking at traditional fixed annuities

TRADITIONAL FIXED ANNUITIES

• The policy specifies a guaranteed minimum interest rate, or floor rate, that remains in effect as long as the policy is in force.

• In terms of their accumulation features, traditional fixed annuities have the following characteristics:

• Annuity values are supported by the full faith and credit of the insurance company.

• In addition, the company declares a current rate of interest that may be in excess of the guaranteed rate or floor rate. This current rate may be guaranteed to stay in effect for one or more years.

• At the end of that time, the company declares a new current interest rate, or "renewal" rate, which may be higher or lower than the previous rate, but not below the minimum interest rate guaranteed by the policy.

 

 

IINDEXED ANNUITIES

As mentioned, indexed annuities are considered to be a type of fixed annuity. Indexed annuity values, like

traditional fixed annuity values, are backed by the full faith and credit of the insurance company and a minimum guaranteed interest rate is specified in the policy.

Where IAs differ from traditional fixed annuities is in the method of determining the current interest rate to credit to annuity values. Instead of declaring a specific rate, as is done with traditional fixed annuities, the company issuing an indexed annuity states that it will credit interest based on the change in value of a specified equity index.

While the insurance company doesn't specify a current interest rate, it does specify the formula for determining the interest rate with reference to that equity index. Because no one knows what will happen to the level of the index, the interest rate to be credited to annuity values cannot be known in advance. Only the minimum contract guarantee is known in advance.

The advantage to an IA contract is two-fold: (1) If the index moves up, you win and earn a higher interest rate. (2) If the index moves down, you are protected by the minimum contract guarantee. "Heads you win; tails you break even." You are allowed to participate in a portion of the upside potential of the market with limited downside risk.

Important IA Terminology

When it comes to the formulas used by insurance companies to determine the interest rate credited to their IA policies, no two are exactly alike. However, being familiar with the important IA terminology explained in this section will help you obtain a better understanding of any IA you may be considering.

TERM

The time period for which certain features of an I A are designed to be in effect. At the end of a term, the annuity owner usually has the option to renew for another term or take the full-accumulated value penalty free. Typically, surrender charges are imposed on withdrawals or surrenders during the term, although there may be certain exceptions. Common terms for IAs range between five and ten years.

PARTICIPATION RATE

The percentage of the measured increase in the index that will be credited to an IAs policy value. For example, if an IA has a participation rate of 75%, and the increase in the index is measured to be 10%, the interest credited to the IAs account value will be 7.5% (75% of 10%). The participation rate is also called the "index rate" for some IAs. Simply put, the client will participate in a portion of the index gains.

Issuers of IAs generally reserve the right to change the participation rate at specified intervals. Some IAs have participation rates that are guaranteed to remain the same for the entire term. Some IAs have participation rates that may change each year.

The participation rates of various IA products should not be compared without also considering the method used to measure increases in the index (discussed later under "Index Growth"). There are different ways to measure the increase in the index, and some of these methods may tend to produce higher results than others, depending on how the level of the index changes. Index growth measurement methods perform differently in different market environments.

It is the combination of the participation rate and the measured increase in the index that produces the interest rate credited to IA policy values. So you need to know how increases in the index are measured as well as the applied participation rate in order to understand how interest credits are determined for a particular IA. Because every IA product has the potential for multiple "moving parts" it is important to understand your product. True "apples to apples" product comparison cannot be achieved without knowing all the "moving parts”.

ADMINISTRATION FEE OR SPREAD

This is a fixed percentage deducted from any increase measured in the index. Many IAs do not have an administration fee. Some IAs use an administration fee instead of a participation rate. An administration fee is sometimes called the "Spread Yield "or" Spread." For example, if an IA has a Spread Yield of 2.5%, and the increase in the index is measured to be 10%, the interest credited to the IA's account value will be 7.5% (10% minus 2.5%). It is important to note in what order the deductions are taken to ensure an accurate comparison.

CAP

Some IAs place a limit on the percentage of interest that will be credited to the policy value. This limit is known as the cap. Since it is expressed as a percentage, it may be called the” cap rate." Any gains earned that exceed the stated cap will not be credited to the policy.

FLOOR

This is the minimum index linked interest rate that will be credited to the policy value regardless of how the index performs. All IAs have a floor. For some IAs, the floor can be as low as 0%. It should be noted that minimum guarantees (see next item) are generally calculated separately from the index based interest calculation and are based on performance over the life of the contract and not on a policy year basis.

CONTRACT VALUE

An IA's minimum guaranteed cash value, sometimes called the reference value or guaranteed policy value.

INDEX GROWTH

The measured increase in the index for a given period of time also, referred to as the index increase.

As mentioned earlier, different IAs use different methods of measuring index growth. Following are descriptions of the major ways various IAs measure index growth, though certain IAs may employ variations on these themes. Measuring methods can include, but will not be limited to:

Point-to-Point: Some IAs measure index growth by comparing the level of the index at the
beginning of the term with the level of the index at the end of the term. The length of the term can vary. This is usually referred to as the “point-to-point" method.

High Water: Some IAs measure index growth by comparing the level of the index at the beginning of the term with the level of the index on the policy anniversary where it was highest. This is usually referred to as the “high-water mark" method.

Binary Reset: These IAs will pay a stated rate as long as the index returns to equal the beginning value or greater at the end of the reset period.

Low Water: These IAs take the lowest anniversary value and allow that to become the beginning index value from the beginning of the contract.

Term High Average Anniversary: These IAs take a rolling annual average of the monthly index values and use highest annual average as the end point.

Fixed Rate with Equity Function: There are two variations of this IA on the market. The first credits a fixed rate to an amount of the premium and the rest participates in the index using an annual reset crediting method. The second credits a fixed rate and also a portion of the term end gains.

Bond Linked: These IAs are linked to US Treasury Notes. An initial rate is set at issue and if the T-note rate is greater at the anniversary, the client will receive the higher rate for the next renewal period. If the T-note rate is lower at the anniversary, the client's rate will be decreased accordingly, but never lower than the initial rate

Monthly Cap: These IAs calculate the index gain over the crediting period by adding each month's gains and losses together. The monthly gains are subject to a cap rate and the crediting period interest cannot be lower than zero.

While each of these measuring methods will produce different results, the one which produces the best result depends on how the index changes during the term of the policy. Since no one can predict how the index will change, it isn't possible to say in advance which method of measuring index growth will produce the greatest increase. The "best" method is the one a particular IA owner is most comfortable with, no matter what changes occur to the level of the index. That is why it is very important to read and understand any IA you are considering.

INDEX INTEREST

The amount of interest credited to an IAs policy value. Index interest is sometimes referred to as index earnings. As mentioned earlier, multiplying index growth by the participation rate or subtracting the spread yield, or both, calculates index interest.

RENEWAL

At the end of a term, the owner of an IA may be given the opportunity to renew the IA for another term. In effect, renewal means using the existing IA fund as the premium to purchase another IA of the same type. If the owner does not wish to renew, he or she has other options, which could include but are not limited to:

• Exchange the IA for another type of annuity;

• Surrender the IA for its cash value; or

• Convert the IA to a stream of income payments.

These options may also be exercised during the term, but in some cases, surrender charges may apply. Many IAs provide a "window”, for example 30 or 45 days at the end of a term, during which these options may be exercised without incurring surrender charges-however, the government-imposed 10% penalty tax may still apply if the owner is under age 59%.

WITHDRAWALS

Most IAs allow their owners to take money out of their annuity without surrendering the contract, but the terms under which this may be done vary from policy to policy. Read your policy carefully. In many cases, IA owners incur a cost to make a withdrawal. This often takes the form of a surrender charge, which is usually calculated as a percentage of the amount withdrawn. With some IAs, withdrawal charges may be waived under certain circumstances - if the amount withdrawn is less than 10% of the annuity's value, or if the owner has been confined to a nursing home, for example.

Withdrawals can reduce the amount of index interest credited to an IA. If money is withdrawn prior to a measuring point, generally no credit is given for the time the money stays in the policy.

Also, an IA owner's access to index credits can be affected by the method used to measure index growth. For example, under the point-to-point method, index interest is credited at the end of the policy term, so there

is no index interest to withdraw prior to the end of the term. Under other methods, index interest may be credited to an IA policy periodically during the policy term. Some policies provide access to these amounts via free withdrawals, while others may effectively limit the amount a policy owner can withdraw by imposing vesting requirements or surrender charges.

In general, any annuity - including an IA - should be considered a long-term savings vehicle. You shouldn't put money into an IA that you expect to need before the end of the policy term. The purpose of withdrawal provisions is to provide some flexibility in case an unforeseen emergency arises. In deciding among different IAs, you may find trade-offs between the liberality of withdrawal provisions and the formulas for calculating interest credits. That is, IAs that offer the greatest potential for interest earnings may be relatively more restricted in terms of withdrawals, and vice versa. Look for an IA that provides a combination of withdrawal provisions and interest crediting potential that seems most comfortable for you.

Are Indexed Annuities Right For You?

Whether an IA is right for you is a question only you can answer after consulting with your financial advisors. However, there are some characteristics that should generally apply to anyone who is considering the purchase of an IA.

An IA may be right for you if:

• You are looking for a long-term savings vehicle and don't expect to need the money you would put into an IA until the end of the term.

• You are comfortable with a varying interest rate that will be credited to your funds, as long as it is subject to a guaranteed minimum and offers
  the potential (but no guarantee) of being higher than those offered on traditional fixed-rate savings vehicles.

• You want to earn interest at a rate linked to increases in an equity index and are willing to forego full participation in the index in return for the principal and minimum interest guarantees associated with fixed annuities.

An Answer For The Risk-Averse Saver

According to a study performed by DALBAR, Inc. (Quantitative Analysis of Investor Behavior, 1994), the 10-year performance of the Standard & Poor's 500 equity index between January 1984 and September 1993 was 293%.Yet during the same period, the average equity mutual fund investor made only 70%.

The reason for the difference was this: in order to realize the 293% return, an investor had to "buy and hold" over the entire 10-year period. Unfortunately, many investors do not buy and hold. When the market goes down, they take their money out, hoping to avoid further losses. While their money is out, they miss many of the market's upswings.

This behavior occurs because of risk-aversion. In trying to avoid losses, risk-averse financial consumers may actually prevent themselves from realizing the gains they seek.

IAs allow risk-averse savers the opportunity to earn a rate of interest linked to equity performance without fearing loss of principal due to market fluctuations, as long as they hold their IAs to term. IA owners need not withdraw their money from their policies during market downturns for fear of incurring losses - they can feel reassured by the fixed annuity's minimum guarantees. They can keep their money in the policy until the markets turn back up, at which point they stand to earn potentially higher rates of interest linked to increases in the equity index.